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Strategic Defaults and Foreclosures: Law Professors Should Stick to the Law

Ken Harney in today’s piece covers a “Discussion Paper” written by Brent T. White of the University of Arizona – James E. Rogers College of Law. In that piece he concludes that more homeowners should default on their mortgages, even if they are able to pay.

I’m not quite so sure what the purpose of a “discussion paper” is. If it’s to start a discussion, fine. If it’s to get people to actually act on the advice given, that I have a problem with. Professor White’s paper has a number of deficiencies, many of which are the result of relying on other false sources, but some of which are just based on a flawed analysis.

The concept of a strategic default is relatively simple. If you bought a house for $580,000 and it’s now worth only $180,000, by staying there today you’re effectively paying $400,000 more than what the house is worth. Professor White argues that the effects of a homeowner defaulting are not that great, and that therefore more homeowners should default. What he finds though is that most don’t, even in areas where prices have declined the most and unemployment is the highest. He considers this behavior irrational, but I consider his analysis flawed.

I don’t really have time to hit on all the faults in the “discussion paper.” One of the minor ones is referencing the fact that today a foreclosed homeowner can get an FHA loan three years after the foreclosure, without noting that may not be true three years from now. Lending standards do change over time, as is evidenced by the fact that lending today is different than lending five years ago. Also, I have a bit of a time with the Professor admitting he doesn’t know how credit scores are calculated, and then stating what the effect on the credit score will be two years down the road. Connecting up the first and second point, he also doesn’t acknowledge that credit scores might not be used for home mortgages in the future. Even today Fair-Isaac has a specialized credit score intended to be used by mortgage creditors, which although probably not widely used today could be in the future. Simply put, you cannot determine the future effects of a foreclosure today, because you cannot determine how banks and others (e.g. insurance companies) will behave in the future.

More surprising is that the “discussion paper” apparently doesn’t contain the word “inflation.” Most all of the number analysis is based on today’s values and doesn’t account for the possibility that inflation will bail out the underwater homeowner. In that regard I would note that the early 80s Seattle condo market was quite similar to today’s market, with many owners being underwater and several projects going to auction. Five years later the situation was considerably different, and even later the owners went to 200% or even 400% appreciation. A condo owner walking away back then would have missed out on those gains, but more importantly, would still need to disclose a foreclosure on a mortgage application today if asked. Simply put, a foreclosure is forever.

What’s perhaps most surprising about this “discussion paper” is how little law is discussed or cited. But perhaps that’s a good thing because the paper incorrectly lists Washington as a non-recourse state, when in reality it’s an election of remedy state. While it’s true most homeowners being foreclosed will not face further liability from a first mortgage creditor, that is not the case at all with a second position mortgage creditor which gets foreclosed out by the first position creditor. Furthermore, although I’m not certain of California law, I believe he overstates the scope of that state being non-recourse. Similarly, I believe he understates the possibility of adverse tax consequences from a foreclosure.

All in all, in my opinion this is a very flawed piece. While there may be times when a strategic default would be warranted, hopefully homeowners underwater will get personal financial advice rather than rely on the advice given in this “discussion paper.”